Netflix makes waves in Hollywood

Epix deal points to high stakes in windows game

For more than a decade, Netflix has been establishing itself as a movie-lover’s best friend, delivering often-hard-to-find DVDs in those distinctive red envelopes.

Now that it has a base of 15 million film-hungry subscribers, Netflix wants to leverage its goodwill to overhaul the nature of its business — eschewing the mail for more cost-effective streaming video — and possibly to rewrite showbiz’s long-held rules for film and TV distribution.

In the past few weeks, Netflix has committed significant coin to rights deals, making Hollywood change its perception of the company as a contender, which was unthinkable even a year ago.

It became a player for pay TV movie rights through its output deal with Ryan Kavanaugh’s Relativity (another company that is shaking up the status quo). It struck an off-network TV deal with Warner Bros. for series that were a tough sell to mainstream basic cablers and local TV stations but perfect for the Netflix aficionado crowd. And it swooped in to offer desperately needed distribution and licensing fees for the partners in fledgling pay TV venture Epix (Paramount, Lionsgate and MGM) in a way that makes Netflix akin to a cable or satellite operator.

This flurry of activity and spending arrives as the majors struggle to understand high-tech changes that are coming at warp speed. From Sony to Google to Apple to Microsoft, all of the tech behemoths are knocking on studio doors offering new ways to distribute their valuable movie and TV franchises.

The industry’s learning curve on digital distribution is steep. But Hollywood pays attention when Netflix commits nearly $1 billion for streaming rights to Epix-distribbed movies over a five-year period.

“We tell (the majors) there is no reason to think of the Internet as being just for piracy and chump change,” says Ted Sarandos, Netflix’s chief content officer and its main pitchman in Hollywood. “We are driving very fast to re-conceptualize the windows business.”

The Epix deal gives Netflix streaming rights to the three studios’ new movies 90 days after the titles debut in the tradition pay TV window.

In the case of Relativity, Netflix is the pay window. “This was the absolute best deal for us because Netflix is becoming ubiquitous in the home. They have 15 million subscribers now and they have devices that are Netflix-ready in 60 million homes.” says Kavanaugh. “The Netflix deal is structured in such a way that it changes the financial playing field vis a vis HBO or Showtime.”

Relativity’s deal with Netflix did not place any restrictions on where and when it could offer its content for streaming to other platforms, unlike studios’ output deals with HBO and other pay cablers. What’s more, Netflix is sharing its detailed usage data with Relativity. “All in all, this deal just makes us so much more competitive, whether it’s sitting down with talent, or striking other deals. The economics just makes us better off than any other studio,” says Kavanaugh.

Still, some in showbiz are wary of giving too much premium content to Netflix out of concern that it will beef up a middle-man service at a time when content producers can (theoretically) go it alone thanks to broadband distribution.

But as the Epix partners have discovered, it’s not easy to make the general public aware of a startup Internet vid service, even if it does have “Iron Man,” “Precious” and other high-profile titles. Starz faced the same problem a few years ago when it launched the now-defunct Vongo movie download service. The Netflix brand and the aud it attracts brings value to the equation.

The deals of the past few weeks have grabbed the attention of film and TV execs on the distribution side because it establishes a clear market rate for the value of streaming rights for fresh theatrical product. Netflix broke ground in this area two years ago when it cut a sublicensing deal with Starz for streaming rights to movies that the pay cabler had through output deals with Disney and Sony Pictures. (The two studios initially were not happy with the sublicensing to Netflix, which led to Starz paying extra to compensate for the additional exposure.)

But the Epix deal is a direct transaction with Par, Lionsgate and MGM for streaming, which sets a market precedent for separating out Web streaming from pay TV rights for a traditional linear channel.

“Netflix did everybody in the industry a favor by establishing that streaming rights have real value,” says a top distribution exec at a major. “The supply of movies is staying relatively steady, but demand for them is increasing … Distributors should be smiling because now there’s someone else to sell to at reasonable rates that wasn’t there two years ago.”

Moreover, Netflix isn’t the only game in town for subscription Web streaming services. Hulu, the Internet vid giant backed by NBC Universal, News Corp. and Disney, is in beta-test mode on its $10-a-month Hulu Plus service, although the focus is largely on TV series for the near term. And Google hopes Google TV will be a consumer-friendly service to aggregate film and TV content for users.

“The more the demand goes up, the more money that flows into buying product,” says the distribution exec.

Since it began offering a streaming option in 2007, Net-flix has nearly doubled revenues and profits. Its subscriber base, too, has more than doubled to a projected 18 million by the end of this year, with subscriptions ranging from $8.99 a month to $23.99 a month. All offer unlimited streaming now, from a library of more than 20,000 movies and TV shows, according to sources. (Netflix says it no longer discloses the number of streaming offerings for competitive reasons.) Netflix declined to talk about how pricing might change if it should opt one day to become a streaming-only service.

Nearly 60 million households, about half of those with TVs in the U.S., now have devices that would allow folks to stream Netflix to their TVs, says Sarandos, pointing out the tremendous upside for their business. Netflix will make its first foray outside the U.S. later this year as a streaming-only service in Canada. It has not yet disclosed pricing.

Netflix’s evolution has come a long way from the days when a former software executive named Reed Hastings thought up a movie rental service after being ticked off at paying late fees for “Apollo 13.” Hastings, now CEO, and his partners launched the Los Gatos, Calif.-based Netflix in 1997, and two years later, it introduced monthly subscription plans — all online without bricks-and-mortar. It eventually tinkered with the model to offer flat-fee unlimited rentals and to eliminate late fees. The company hit its stride in 2002 when it went public (the share price has risen nearly sevenfold since) and posted its first profits a year later. Netflix also distinguished itself by becoming a home for more obscure independent and art films not readily available at other retailers, so it drew an eclectic following beyond the usual fans of firstrun movies.

Yet nothing has been more significant to Netflix than its plunge into online.

Netflix’s “destiny” is to become a full-blown streaming service, adds Sarandos. “You could say we are in DVD maintenance mode at this time.”

It’s not hard to understand why. To send and have a DVD returned, Netflix pays 90¢ — but it costs the service a nickel to stream a movie, according to research from J.P. Morgan analyst Imran Kahn. Streaming has lowered subscriber turnover, or churn, by at least a percentage point, says Kahn, adding that the move to streaming will help fund future content acquisitions.

The percentage of Netflix subscribers who have streamed a movie or TV show for at least 15 minutes has nearly doubled in the past year, to about 70%.

Execs involved with Epix saw the partnership with Netflix as a unique opportunity to reach two very different sectors of the movie-consuming audience.

“You get the people who are rejectors of pay TV and you get the people who pay for multiple pay services and want everything no matter how much they already get,” said Mark Greenberg, president of Epix.

Netflix also delivers a younger demographic than the average pay TV subscriber, Greenberg says.

Epix was in need of a major distribution partnership because the three studios gave up the opportunity to collect pay TV money from an outside company (Par, Lionsgate and MGM had been under output deals with Showtime before teaming on Epix) in order to launch their own premium channel to distribute their pics via pay TV and Internet. Since October, the channel has lined up about 5 million subscribers and is available in about 30 million cable, satellite and telco homes through carriage deals with Dish Network, Charter Communications, Cox Communications and Verizon’s Fios, among others. But even with a growing base of paying customers, it’s still not enough to offset the losses that the partners were absorbing by forgoing pay TV revenue. And that’s where Netflix came in.

Netflix was pitching Epix on a streaming deal from the time the venture was formed in April 2008. But the partners felt that Netflix had reached critical mass as a business only in recent months.

“They’re like a small MSO,” Greenberg says, referring to the multiple system cable operators. “I think they’re being really smart about the way the define themselves.”

The Epix-Netflix pact raised questions about whether Epix will be able to crack the three largest subscription TV platforms: Comcast Corp., DirecTV and Time Warner Cable. A number of biz observers say that the exposure on Net-flix will hurt Epix’s cause with the operators who see Netflix as fast-rising competition encroaching on their turf with movie titles and selectively with TV. The optimistic view posits that now Comcast and the other two will have to add Epix to their program menu, lest their competitor offer content that they can’t match.

But the challenge for Netflix will be to find large libraries to beef up its streaming offerings. One obstacle: HBO has movie output deals with Warner Bros., New Line, Fox, Universal and DreamWorks Animation that extend another five years. That includes streaming rights, which HBO is putting to use with its new HBO Go broadband service, which allows subscribers to watch movies and original shows like “True Blood” and “Entourage” online.

HBO executives said recently they were not interested in negotiating a deal to allow Netflix to stream its popular catalog of original programming. Showtime too, says it has no plans to offer current episodes of its original series, such as “Dexter,” to Netflix, though the show is available once each season is released on DVD.

Sarandos downplays any looming battle with HBO. Net-flix has deals with studios whose releases this year will account for 46% of domestic box office, he says, while he points out that HBO’s deals cover 45% of box office. Netflix and HBO are complementary services, he says, citing the San Francisco market, where Netflix has 26% penetration and HBO has 29%.

Hulu may be of more concern, especially now that executives are said to be mulling an IPO as a way to fund more content, especially to feed its new Hulu Plus subscription service. For now, Sarandos says he’s not too worried. “It is very hard to transition (your customers) from free to pay,” he says.

Netflix is certainly no stranger to slaying competitors. The Tower Records, Movie Gallery and Hollywood Video chains are dead and buried. Blockbuster, begging for extensions on its debt obligations, teeters on the brink of bankruptcy. The closure of video rental stores in 2010 alone puts $1 billion in annual rental spending “up for grabs,” says J.P. Morgan’s Khan, with kiosk businesses like Redbox the most likely to benefit. But it also presents opportunities for Netflix, Khan adds.

The trick for Netflix will be to seize those opportunities while boosting its subscription revenue to offset what it will need to spend for content. Those costs will increase by $357 million in the next year or so, estimates Khan. What’s more, the Netflix deal with Starz is coming due in the next two years, say sources, with the premium channel most certainly looking for big increases, given what Netflix paid for its Epix deal.

Netflix pays Starz about $26 million a year for streaming rights, vs. the $200 million it will pay the Epix partners. Sarandos won’t comment on the Starz deal, other than to say “we expect to pay significantly more than we did in the first round.”

Looking forward, Sarandos says it is necessary to look back. Five years ago, Hollywood’s windows model and the TV syndication business were firmly entrenched, he says. “What we have been able to do is create a more competitive environment for content. Our biggest challenge will be navigating this rapidly changing landscape.”